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Portugal’s Banking Sector – Safe or Not

August 3rd 2014, was the day Banco de Portugal was forced to split the second largest bank in the country to rescue the Portuguese economy from any further damage. Banco Espírito Santo, S.A.(BES) reported huge losses due to the parent group, Espirito Santo’s default on regular debt payments. Portugal was able to bailout BES with €4.9 billion but it had to erode the cash buffer saved from its own bailout fund under IMF-EU programme. This event caught the global attention and there were concerns about the financial stability of the euro-zone. Economy of 18 countries in European Monetary Union (EMU) using common currency ‘Euro’ was still recuperating and European Central Bank (ECB) had to define the way forward for the proposed common banking union. Any distress signal from euro-zone could increase the contagion threats and vulnerabilities of the global financial markets.

The Portugal Economy

The year 1974 marked the beginning of the current democratic era of Portugal. The first regional elections were held in 1976, the first full-fledged parliamentary elections. Mario Soares became the first Prime Minister and the country got its new constitution. Subsequently, Portugal had several changes in governing political party. Portugal joined the European Union in 1986 and was among the initial countries which adopted Euro as currency in 1999. In 2002, Euro as a currency completely replaced the erstwhile currency Escudo...........

Portugal - Post 1974

Nation observed its Carnation Revolution3 in 1974 that ended the earlier authoritarian ‘Estado Novo’ regime and started the era of democracy. The earlier regime encouraged and created conditions for the formation of large business conglomerates and these conglomerates still control large part of economy. BES’s parent group ‘Espirito Santo’ was one such empire whose interests ranged from European banks to Miami condos to a diamond mine in Angola. Its patriarch Ricardo Espirito Salgado was nicknamed “Dono Disto Tudo,” or “Owner of All This.”...........

Joining the Euro

EU and its common currency ‘Euro’ € were established with the signing of 1992 Maastricht Treaty. The treaty specified criteria for countries to become part of EMU like budget deficit should be less than 3% of GDP, debt to GDP should be less than 60%,convergence over inflation (inflation should be less than lowest three inflation rate +1.5%), interest rate convergence (the nominal interest rate must not be more than 2% points higher than in the three lowest inflation member states)...............

Portugal’s Economic Slump Prior to European Debt Crisis (2000-2007)

Portugal was growing rapidly between 1995 and 2000 but faced economic slump after 2000. During 2000 to 2007 real capita GDP growth in Portugal was 0.61% p.a. as opposed to 1.34% in the Euro area. Considering that Portugal was relatively the poorest of 12 Euro area nations, this was dismal performance. Several reasons have been cited in the literature for the slowdown. (i) Poor schooling: In 1975, among those with age of more than 25 years................

Finances of Portugal’s Government

Government budget deficit (revenue - expenditure) kept rising over time (Exhibit I) and so did government debt as percentage of GDP (Exhibit II). From 2006 Portugal’s net external debt remained higher than 50% of GDP (Exhibit II). A government cannot sustain such a high debt of above 60% of GDP for too long and could result into severe debt crisis. Gross domestic savings as a percentage of GDP declined, recording lowest rate of 12.46% in 2010................

Surviving the Euro Crisis

Real difficulties started with 2007-8 global financial crisis which originated in USA with multiple collapses in financial sector. The contagion spread fast to Europe and EU observed 0.4% GDP growth rate in 2008 followed by (-)4.5% growth in 2009. EU tried to recover from this but soon it was hit by sovereign debt troubles in 2010............

Exiting the Bailout

In May 2014, Portugal on its own political will decided to exit from the €78 billion IMF-EU bailout programme. But there were negative signals for the investors as its economy was not in a good shape (Exhibit V, Exhibit I and Exhibit VI)...........

Portugal Banking Sector

Since 1933, the pre-revolution period of Portugal, business houses remain the prime driver of economic growth. The Portugal’s banking system was also knitted with the complex ownership structures and parallel accounting system. This system is a result to lax banking regulations of Banco de Portugal (Portugal’s central bank) which is part of the European System of Central Banks (ESCB) since its inception in 1998. ESCB consists of European Central Bank (ECB) and the national central banks of the European Union (EU)..............

Portugal Banking Crisis

There was some turmoil in the capital markets on July 10th 2014 like Lisbon’s benchmark PSI 20 stock index slumped 4.2%, BES credit rating was downgraded, and its shares fell 19%22. As an immediate response to this, regulators stopped the share trading of BES for rest of the day.

This press release said that BES was safe and things were under the regulatory control of central bank of Portugal...........

Teaching Note Preview

Portugal’s Banking Sector – Safe or Not

The case describes how Portugal got into a self-created debt crisis followed by banking crisis. The period of the case is post democratic revolution of 1974 with particular emphasis on post European Monetary Union (EMU) period. Portugal was one of the first set of countries to be part of EMU in 1999. After joining European Monetary Union, Portuguese economy faced economic slump during 2000-2007 and the economic performance of Portugal was below the average for Eurozone. Portugal along with Ireland, Italy, Greece and Spain (PIIGS) faced sovereign debt crisis in 2010. Portugal was able to survive the Euro debt crisis with the help of Troika (EU-ECD-IMF) bailout. Troika bailout package involved stringent conditionality, which required fiscal austerity. As fiscal austerity began biting there were strikes and political uncertainty in Portugal. Hence, at the earliest signs of stability and recovery, Portuguese government decided to exit the bailout program in May 2014. Some observers believed that bailout programme had a positive impact on Portugal’s economy and after following four years of strict austerity measures and that Portugal was ready to its chart future course on its own without need for bailouts. However, reality seems to contradict this opinion and in July 2014, country’s third largest commercial bank BES collapsed. Portugal government had to rescue the BES with €4.9 Billion. This bailout eroded the nation’s reserves saved from IMF-EU bailout. The moot point is that ‘Was Portugal bit too hurried to get out of the bailout?’

Case Positioning and Setting

This case study may be used at MBA level in a course on International Finance or International Economics

Expected Learning Outcomes

• Understand the inter linkages of macroeconomic variables• Understand the implications of fiscal profligacy• Appreciate the difficulties of sustaining common currency area like, EMU and constraints imposed on member countries by common currency• Understand the factors leading to unstable banking system in Portugal and the importance of sound banking regulations

Assignment Questions

I. Whose fault is it that Portugal ended up in economic crisis?II. How sound was the Portugal’s economy in 2013?III. ...................

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Product code: ME-1-0004, ME-1-0004A

Abstract

In May 2014, Portugal, on its own political will, exited the 3-year EU-IMF supported bail-out programme. Portugal had to accept €78 billion EU-IMF-led bailout in 2011 to manage its public debt. The bailout required severe austerity measures leading to public disapproval and protests. Analysts raised doubts about the economic success during the bailout and were even more worried about the Portuguese economy post the bailout exit. Barely few months later, in August 2014, Portugal’s third largest bank Banco Espírito Santo, S.A. (BES) collapsed after reporting heavy losses (€3,577 million). Portugal was able to save the bank with €5 billion but this eroded the nation’s buffer capital that was saved from the EU-IMF bailout fund.

This case revolves around two broad questions. First question being, what led to Portugal’s sovereign debt crisis and whether and how the EU-IMF bailout has helped its economic resurgence? Next round of elections due in 2015 will exert its own set of pressures on the government expenditure. Portugal’s government debt to GDP ratio has been increasing sharply, and is at 129% in 2014. Will this be sustainable in the long run?

Second question is about Portugal’s banking system problems and factors leading to the collapse of BES. Portugal’s bank non-performing loans to total gross loans was 11% compared to 3% of Germany in 2013. Like BES there could be several banks in the Euro zone who could suffer such huge losses. Multiple of such collapses will lead the contagion spread and if that happens then there could be a Euro zone banking crisis similar to its sovereign debt crisis. Health of the financial system is a pre-requisite for a sustained recovery in Portugal as well as in Euro zone. Hence, the pertinent question is how safe is Portugal’s banking system?

Pedagogical Objectives

To understand the inter linkages of macroeconomic variables

To understand the implications of fiscal profligacy

To appreciate the difficulties of sustaining common currency area like EMU and constraints imposed on member countries by common currency

To understand the factors leading to unstable banking system in Portugal and the importance of sound banking regulations

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